Gross Margin Analysis: What to Consider after You’ve Figured Profitability

May 23, 2018

“Am I making money on what I’m selling?”

For a quick, reliable answer to this deceptively simple question, conduct a gross margin analysis.

This reality check can reveal early warning signs that a more detailed assessment is needed and when it’s not.

Gross margin is the difference between what you’re paid for a unit of product or service and the direct expenses associated with it, without considering various overhead costs.

If the basic cost of making one widget is $100, and you sell them for $150, your gross margin is $50 per unit. Simple enough.

There are two ways to express gross margin as a percentage:

  • Mark-up percentage: The $50 mark-up is divided by the basic cost to make each widget ($100), which is 50 percent.
  • Margin-on-sales percentage: The more common method. Divide the $50 mark-up amount by the sales price ($150) to get 33 percent.

What is Healthy?

There is no magic “good” or “bad” gross margin percentage that applies to all enterprises.

A healthy gross margin for you might be woefully inadequate, or impossibly high, for another company. Other factors come into play that determine what a strong or weak gross profit would be for you, such as sales volume and overhead costs.

After all, you will have to decide how good is it for your business to have a 50 percent gross margin on a product that costs $100 to make, if you only sold one unit a day?

Suppose you know that over the past year, your net profit (EBITDA) was 15 percent of your gross revenue, and that you were happy with that result. Further suppose that your gross profit per unit, based on that year’s numbers, was 50 percent. In this scenario, if your gross margin per unit keeps cooking along at 50 percent every month in the current year, you’re probably in good shape.

Heed the Warning Signs

If competitive or macroeconomic conditions have forced you into deep discounting, and your gross profit margin starts drifting down around 25 percent in this case, that’s a red flag. You must find a solution and revise your strategy.

Here are some steps you can take to perform root-cause analysis and act:

  • Understand performance and root causes: Are you selling more or less of certain products or services in your portfolio? If so, keep an eye on multiple gross margin figures, concentrating on the products and services that are your largest source of profits. The more gross profit historical data you collect, the easier it will be to interpret the current period to plan for improvements.
  • Check and act: Validate data, verify it is the right information, and act upon it. Then, incorporate in your improvement efforts, a comprehensive solution that combines raising sales volume and reducing expenses. You must control your cost.
  • Hold your horses: It is usually best to avoid hitting the accelerator or the brake pedal at the first sign of unfavorable gross profit patterns. Naturally, you want to reverse a negative trend. But focus on steady, continuous improvements in profitability, instead of wild swings between red and black ink. A reactionary pattern can do more harm than good.
  • Remember that decision-making comes along with organizational changes, and you must consider all factors when rolling out initiatives that will improve your bottom line.

Summary: Gross Margin Analysis

Gross margin analysis is a simple yet helpful tool for monitoring financial performance.

When a more detailed analysis is called for, your CPA-led business advisory firm can provide the insights and guidance you need.